Emergence of Modern Islamic Banks

The traditional banks serve the important role of financial intermediaries to pool the resources from many small investors to finance large capital projects. This role is important for functioning of modern economy as individual investors do not have the resources to determine suitable projects matched to their needs and manage inherent risks. As Shari’ah does not prohibit such role, developers of Islamic banking have endorsed this function for Islamic banks.

In the traditional banking system, the bank is obligated to pay interest to the investor regardless of the outcome of the bank’s investments. If the bank makes risky investment and the project fails, the bank might fail as well if enough losses are incurred by the bank. This was proven in 2008 US financial crises when banks loaned tremendous amounts of money to unqualified home buyers who did not have the capacity to pay back. This almost melted the entire financial system and was saved only by government intervention. Due to the sharing of risk and reward by all parties in an Islamic financial system, banks as intermediaries are more careful in their investments. The Islamic banks use one of the Shari’ah compliant methods to generate income through leasing or profit.

When applied on global scale, the role of financial intermediary evolves into economic development for less developed countries. Nations with excess capital can use the banks to invest in profitable projects in poor countries. Islamic Development Bank (IDB) was formed to provide such a function in according to Shari’ah. As private Islamic banks have grown over last 30 years, this role of economic development is slowly being taken by these banks. The Islamic banks are involved in for profit infrastructure development and trade financing projects. As the capital base of these banks is small, the size of projects they can undertake also remains small.

All Shari’ah compliant modes of financing can be applied for economic development. Musharakah and Mudarabah can be adapted for project, import, export, or working capital finance. Resources of several banks can be pooled to fund huge infrastructure projects requiring billions of dollars investment. Murabaha and Salam can be useful in increasing employment, providing liquidity, funding small projects (micro-finance), and improvement of economy. Salam can be especially used for financing agricultural crops. There is potential room for tremendous growth in this area. By channeling excess wealth of cash rich countries towards those in need of development, Islamic banks can help Muslim world fight poverty, develop their economies, grow internal talents, and get accounted among leading nations of the world.